Y^SVt-cr.L 


^5 


Reprinted  from  The  Annals  of  the  American  Academy  of  Political  and  Social 
Science,  Philadelphia,  November,  1919. 

Publication  No.  1338. 

Financial  Needs  of  the  Railways 

By  Julius  H.  Parmelee 

Statistician,  Bureau  of  Railway  Economics,  Washington,  D.  C. 

A NY  attempt  to  forecast  railway  finances  is  a hazardous  pro- 
ceeding  at  the  present  time,  owing  to  the  uncertainty  that 
surrounds  the  future  of  the  American  railway  system.  In  what 
follows,  the  underlying  assumptions  are  that  the  President  will 
adhere  to  his  decision  to  return  the  railways  to  their  owners  at 
the  close  of  the  present  year;  that  they  will  thereupon  continue 
under  private  management  and  ownership,  with  such  modified 
provisions  for  regulation  and  rate-making  as  may  be  imposed  by 
Congress;  finally,  that  these  modifications  will  almost  certainly 
be  such  as  to  have  a bearing  on  railway  credit  and,  therefore,  on 
the  ability  of  the  railways  to  finance  their  needs. 

The  problem  of  railway  financial  needs  may  be  studied  under 
three  principal  heads:  First,  the  physical  needs  of  the  railways; 
second,  the  cost  of  such  physical  needs;  third,  how  such  cost  is 
to  be  financed. 

Physical  Needs 

In  a sense  the  present  article  is  a companion  to  one  by  the  writer 
in  The  Annals  for  March,  1918,  which  endeavored  to  reach  an 
estimate  of  the  physical  needs  of  the  railways  while  under  federal 
control.  It  was  estimated  that  the  railways  of  the  United  States, 
during  the  period  of  federal  control,  would  be  under  the  necessity 
of  putting  not  less  than  $500,000,000  a year  into  their  property 
in  the  form  of  additions  and  improvements  to  plant.  This  esti- 
mate was  based  on  an  annual  addition  of  500  miles  of  main  line, 
2,500  miles  of  other  tracks,  2,000  new  locomotives,  50,000  new 
freight  cars,  and  various  terminal  and  other  facilities.  By  “new” 
locomotives  and  cars  is  meant  net  additions,  over  and  above 
replacement  needs.  The  record  for  1918,  which  of  course  was 
not  available  at  the  time  that  article  was  written,  shows  that 
there  were  added  to  railway  equipment  during  1918  about  1,000 
new  locomotives,  no  freight  cars,  and  no  passenger  cars.  In  fact, 
the  number  of  freight  and  passenger  cars  built  during  1918  was 
probably  insufficient  to  replace  those  retired  for  various  causes. 


i 


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The  Annals  of  the  American  Academy 


The  conclusion  is  inevitable  that  the  railways  will  face  a heavy 
improvement  program  when  they  regain  control  of  their  prop- 
erties. 

To  arrive  at  an  idea  of  future  financial  needs,  one  must  also 
have  some  knowledge  of  physical  needs,  and  that  in  turn  depends 
on  an  estimate,  or  guess,  as  to  what  the  demands  of  traffic  will  be. 
Growth  of  traffic  has  been  very  unusual  during  the  past  few  years. 
In  discussing  this,1  I have  shown  that  whereas  for  several  years 
up  to  1915  the  annual  increase  in  ton-mileage  was  about  4 per 
cent,  and  in  passenger-mileage  about  2 per  cent,  the  increase  from 
1915  to  1917  was  at  the  rate  of  about  20  per  cent  a year  for  ton- 
miles  and  nearly  7 per  cent  for  passenger-miles.  Bringing  the 
statistics  down  to  a later  date,  we  find  that  the  results  thus  far 
recorded  for  1919  show  traffic  increases  over  the  corresponding 
period  of  1915  approximating  30  per  cent,  or  an  annual  average 
of  about  7 per  cent  over  a four-year  period.  Freight  traffic  during 
the  first  eight  months  of  1919  was  less  by  about  one-seventh  than 
during  the  corresponding  months  of  1918  and  1917.  Even  so, 
the  annual  rate  of  increase  since  1915  has  been  much  greater  than 
during  the  period  just  preceding  1915.  This  unusual  recent 
growth  in  traffic  may  be  ascribed  in  part  to  the  war,  which  undoubt- 
edly had  a very  definite  influence;  on  the  other  hand,  the  year 
1919  has  been  for  the  United  States  a time  of  comparative  peace. 
Again,  the  next  few  years  will  doubtless  see  a large  amount  of 
traffic  due  solely  to  the  necessities  of  the  reconstruction  period. 
We  are  reasonably  safe,  therefore,  in  counting  on  a growing  de- 
mand for  transportation  for  some  years  to  come.  That  means 
increased  physical  needs,  and  at  the  greatly  increased  prices  now 
prevailing,  as  compared  with  those  of  the  pre-war  period,  the 
conclusion  is  again  inevitable  that  the  future  need  of  the  railways 
for  new  money  will  be  very  great. 

Another  point  in  this  connection  is  that  there  was  a necessary 
slackening  of  railway  improvement  work  during  the  war,  which 
was  not  in  any  sense  obviated  thereby,  but  was  for  the  most  part 
merely  deferred  to  a later  date. 

When  improvements  are  deferred  who  is  it  that  suffers?  Chiefly 
the  public,  who  must  pay  unnecessarily  high  rates  for  service 

1 See  article  already  referred  to.  Annals,  March,  1918,  especially  pages  43 
and  44,  where  the  growth  of  traffic  from  1915  to  1917  is  described. 


Financial  Needs  of  the  Railways 


3 


that  is  below  standard.  When  the  roads  are  returned  to  private 
management,  will  they  not  look  back  over  a period  when  railway 
improvements  did  not  keep  up  with  the  growth  of  traffic?  If  so, 
it  will  take  an  unusual  amount  of  financing  to  carry  them  through 
the  period  of  readjustment.  Examples  of  how  the  railways  were 
bending  every  energy  to  make  improvements  demanded  by  the 
public  (before  government  control)  have  come  to  light  with  the 
filing  by  numerous  railways  of  applications  with  the  Railroad 
Administration  for  a larger  income  guarantee  than  the  standard 
return  shown  by  their  annual  reports  for  the  three-year  test  pe- 
riod. These  applications  for  an  increased  guarantee  are  based 
for  the  most  part  on  the  unusually  heavy  expenditures  for  addi- 
tions and  betterments  just  prior  to  and  during  the  test  period. 
Railway  managements  during  this  period  were  trying  to  keep  their 
plants  up  to  the  requirements  of  the  growing  territory  served, 
and  if  they  were  meeting  with  difficulty  then,  how  much  greater 
will  be  the  problem  in  the  future?  All  signs,  then,  point  to  heavy 
financial  burdens  for  the  railways  in  the  future.  Traffic  growth 
will  continue  to  demand  new  railway  facilities,  and  in  addition 
there  is  the  slack  of  the  past  two  years  that  must  be  taken  up. 

Financial  Needs 

As  an  essay  in  prophecy,  let  us  assume  that  the  traffic  in  1920 
and  succeeding  years  will  be  one-third  greater  than  in  1916  (1919 
having  been  nearly  one-third  greater  than  1915),  and  that  it 
cannot  be  efficiently  handled  without  at  least  a ten  per  cent  in- 
crease in  equipment  and  other  facilities.  I take  1916  rather 
than  1915  as  a basis  of  comparison  because  it  was  the  best  traffic 
year  in  the  history  of  the  American  railways,  up  to  our  entry  into 
the  war.  This  would  mean  that  as  soon  as  practicable  after  the 
first  of  January,  1920,  railway  investment  should  be  increased  to 
such  an  extent  as  to  be  greater  than  in  1916  by  from  $2,000,000,000 
to  $2, 500, 000, 000, 2 As  a matter  of  fact,  less  than  $1,500,000,000 

2 Railway  investment  was  about  $17,500,000,000  on  June  30,  1916.  A 10 
per  cent  increase  in  facilities,  assuming  price  levels  to  remain  constant,  would 
mean  an  addition  to  investment  of  $1,750,000,000.  But  prices  having  increased 
from  50  to  100  per  cent  since  1916,  it  does  not  seem  unreasonable  to  estimate 
that  $2,500,000,000  may  be  more  nearly  the  present  cost  of  the  needed  10  per 
cent  increase  in  facilities  than  $1,750,000,000.  This  10  per  cent  estimate  of 
needs,  considering  the  tremendous  jump  in  traffic  since  1916,  seems  to  me  very 
moderate. 


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The  Annals  of  the  American  Academy 


will  have  been  invested  by  the  close  of  the  present  year.  In 
other  words,  the  railways  have  fallen  perhaps  $1,000,000,000,  or 
more  than  a year’s  needs,  behind  their  normal  program  during 
the  past  three  or  four  years.  This  gives  some  indication — 
although  it  is  only  approximate — of  the  extent  of  slackening  in 
improvement  work.  In  addition,  the  roads  should  have  not  less 
than  $500,000,000  a year  to  keep  up  with  the  growing  needs  of 
the  country.  In  fact,  the  amount  ought  probably  to  be  stated 
as  above  $600,000,000,  or  (if  allowance  be  made  for  the  extent  to 
which  the  railways  must  catch  up  on  their  improvement  pro- 
gram) as  high  as  $750,000,000.  This  annual  addition  of  from 
$500,000,000  to  $750,000,000  is  predicated  in  part  on  the  normal 
pre-war  expenditure  of  $468,000,000  a year  (which  was  the  average 
of  the  years  1913  to  1917),  with  an  allowance  for  increased  prices, 
in  part  on  the  estimate  for  the  period  of  federal  control  already 
referred  to,  and  in  part  on  the  record  actually  made  by  the  United 
States  Railroad  Administration.  The  Railroad  Administration 
naturally  made  only  the  most  needed  additions  and  improvements, 
leaving  to  the  period  of  renewed  private  control  the  less  necessi- 
tous demands  for  additional  facilities.  Yet  with  all  this,  the  cap- 
ital expenditures  authorized  by  the  Railroad  Administration  in 

1918  amounted  to  $851,000,000.  This  was  not  necessarily  a 
one-year  program,  it  is  true,  yet  with  the  authorizations  made  in 

1919  the  annual  average  promises  to  be  well  over  $500,000,000. 
This  is  in  spite  of  the  fact  that  authorizations  in  1919  were  pared 
to  the  bone,  due  probably  as  much  to  the  impoverished  condition 
of  the  Railroad  Administration  treasury  as  to  the  fact  that  the 
fighting  was  over  and  the  return  of  the  roads  to  their  owners  was 
looming  on  the  horizon.  Director  General  Hines’  statement  to 
the  House  Sub-committee  on  Appropriations  in  June  (Hearings, 
page  144)  on  this  point  is  as  follows:  “Our  definite  policy  is  that 
we  are- not  going  to  make  any  capital  expenditures  for  the  year 
1919  for  these  companies  unless  they  finance  them  themselves 
or  unless  they  are  of  such  an  urgent  character  that  we  must  go  ahead 
with  them  in  advance  of  arranging  the  financing . ” (Italics  mine.) 

Whether  the  annual  needs  prove  to  be  half  a billion,  or  three 
quarters  of  a billion,  the  amounts  seem  like  enormous  sums,  and 
they  are.  But  we  are  dealing  with  a gigantic  industry  whose 
invested  capital  is  already  nearing  twenty  billions  of  dollars,  and 
whose  needs  are  constantly  growing. 


Financial  Needs  of  the  Railways 


5 


Financing  the  Needs 

Before  taking  up  the  question  of  financing,  let  us  glance  for  a 
moment  at  the  distinction  between  cost  of  maintenance  and  cost 
of  improvements.  To  maintain  the  railway  properties  in  such 
shape  as  to  keep  them  fit  to  function  properly  and  adequately 
calls  for  an  annual  expenditure  running  into  many  hundreds  of 
millions.  In  1918  it  cost  the  United  States  Railroad  Adminis- 
tration $1,737,000,000  for  maintenance.  This  expenditure  is,  how- 
ever, a current  expense,  normally  met  out  of  operating  revenues. 
For  the  purposes  of  the  present  discussion,  it  will  be  assumed 
that  rates  will  continue  to  be  so  adjusted  as  to  cover  maintenance 
costs.  No  special  question  of  financing  therefore  arises  in  that 
connection. 

Improvement  costs  fall  into  a wholly  different  category.  Im- 
provements are  of  two  general  types — either  they  consist  of 
extensions  of  railway  lines  into  new  territory,  or  they  represent 
the  betterment  of  railway  property  already  under  operation, 
including  both  the  stationary  plant  and  the  equipment.  The 
latter  type,  denominated  for  the  most  part  by  the  Interstate 
Commerce  Commission  as  “additions  and  betterments,”  is  far 
more  important  than  the  former,  inasmuch  as  the  amount  of  new 
railway  construction  has  been  very  small  in  recent  years.  Both 
types  are  capital  improvements,  their  primary  cost  has  but  little 
relation  to  operating  expenses,  and  the  money  investment  they 
represent  must  appear  in  the  railway  balance  sheet  as  part  of 
the  property  assets. 

The  cost  of  improvements  can  be  financed  in  only  two  ways — 
either  it  is  met  out  of  surplus  accumulations  from  the  earnings  of 
the  current  or  former  years  and  specifically  appropriated  by  rail- 
way boards  of  directors  for  the  purpose,  or  it  must  be  financed 
through  the  issue  and  sale  of  new  securities.  During  the  calendar 
year  1917  railways  of  Classes  I and  II  (which  own  or  operate 
about  99  per  cent  of  the  total  railway  investment)  added  to  their 
property  investment  about  $572,000,000.  It  is  difficult  to  as- 
certain with  exactitude  how  this  $572,000,000  was  financed,  but 
we  know  from  a general  study  of  the  comparative  balance  sheets 
at  the  beginning  and  close  of  the  year,  and  the  income  and  profits 
and  loss  accounts  for  the  year,  that  considerably  less  than  a fifth 
of  the  amount  came  from  earnings.  It  follows  that  a large  pro- 


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portion  of  any  railway  financing  must  be  done  through  the  sale 
of  securities,  while  only  a fraction  can  be  provided  for  out  of 
surplus  earnings. 

If  the  American  railways  are  to  need  from  a half  to  three- 
quarters  of  a billion  dollars  a year,  it  is  a vital  question  how  the 
financing  is  to  be  carried  out.  In  the  past,  the  railways  and 
their  bankers  have  had  no  great  difficulty,  on  the  whole,  in  con- 
vincing the  investor  as  to  the  integrity  of  railway  securities.  Of 
late  the  task  has  grown  continually  more  difficult,  and  the  tend- 
ency of  capital  to  flow  into  industrial  rather  than  railway  chan- 
nels has  been  marked.  In  the  future,  much  will  depend  on  the 
form  that  railway  organization  will  take,  and  particularly  on  the 
extent  to  which  the  government  becomes  a partner,  if  at  all,  in 
railway  responsibilities.  If  the  government  should  go  to  the 
extent  of  guaranteeing  future  issues  of  railway  securities,  interest 
or  principal  or  both,  the  problem  would  be  much  simplified. 
This  seems  hardly  probable.  If  the  number  of  railway  corpora- 
tions is  much  reduced,  a&  appears  more  likely,  the  problem  will 
be  simplified  in  a different  way,  in  that  railway  credit  will  depend 
on  the  average  results  of  a considerable  number  of  railway  units 
combined  in  a single  large  unit.  But  the  complications  involved 
in  uniting  these  smaller  units,  so  as  to  preserve  their  properties 
intact  and  maintain  the  priorities  of  the  mortgage  rights  involved, 
are  so  great  that  the  whole  question  of  enforced  consolidations 
still  seems  to  me  an  open  one.  In  any  case,  this  is  not  the 
place  to  enter  upon  that  discussion. 

While  it  is  difficult,  almost  to  the  point  of  impracticability,  to 
indicate  how  railway  financing  will  be  done  in  the  future,  it  may 
not  be  amiss  to  point  out  that  recent  tendencies  in  the  field  of 
railway  credit  ought  not  to  continue.  With  a few  notable  excep- 
tions there  have  been  no  new  issues  of  railway  stock  for  the  past 
five  or  six  years.  Capital  stock  has  replaced  bonds  in  the  process 
of  reorganizing  some  railway  companies,  but  the  amount  of  new 
stock  issued  and  sold  for  cash  in  the  open  market  has  been  rela- 
tively very  small.  Even  in  the  case  of  railway  bonds,  there  has 
been  growing  difficulty  in  placing  new  issues,  and  many  of  the 
less  prosperous  roads  have  been  forced  to  the  costly  expedient  of 
issuing  short-term  notes,  selling  them  frequently  below  par  and  at 
high  rates  of  interest.  As  a result  of  this  process  of  financing 


Financial  Needs  of  the  Railways 


7 


through  bonds  rather  than  stock,  railway  security  holders  are 
becoming  creditors  of  the  railways,  rather  than  owners.  Railway 
bonds  today  constitute  60  per  cent  of  total  railway  securities 
outstanding  in  the  hands  of  the  public.  Fixed  charges  are  grow- 
ing, and  the  present  tendency  unless  checked  will  at  the  same 
time  increase  the  annual  burdens  of  the  railway  companies  and 
decrease  their  ability  to  finance  their  future  needs. 

This  note  of  warning  is  not  uttered  in  a pessimistic  spirit,  but 
merely  in  the  hope  that  those  who  are  responsible  for  the  future 
of  the  American  railways  will  make  it  possible  for  them  to  secure 
the  capital  needed  for  their  growth  on  a basis  equitable  both  to 
the  investor  and  the  companies,  and  that  a large  proportion  of 
the  new  capital  will  be  stock,  reasonably  assured  of  a fair  rate  of 
dividends. 

There  is  one  phase  of  this  question  which  I have  thus  far  passed 
over  as  being  merely  incidental,  although  in  itself  it  is  an  im- 
portant matter.  I refer  to  the  amounts  which  the  Railroad 
Administration  will  have  advanced  and  expended  on  behalf  of 
the  railways  for  new  equipment  and  improvements,  a large  pro- 
portion of  which  will  not  have  been  repaid  by  the  railways  when 
they  are  returned  to  their  owners.  In  part,  these  amounts  will 
probably  be  funded  under  some  form  of  long-term  agreement  by 
which  the  principal  will  be  reduced  by  annual  installments  paid 
by  the  railways  to  the  government;  in  part,  it  is  proposed  to  fund 
the  $400,000,000  expended  for  new  equipment  by  a joint  equip- 
ment trust,  in  which  the  government  and  the  railways  will  partic- 
ipate, also  payable  by  annual  reduction  of  principal  and  interest. 
While  the  final  details  remain  to  be  worked  out  as  this  is  written, 
it  is  inconceivable  that  the  railways  will  not  be  allotted  reasonable 
time  and  means  to  meet  the  obligations  to  the  government  which 
the  war  conditions  virtually  forced  on  them.  The  principal 
bearing  of  this  phase  of  the  question  on  the  larger  problem  of 
future  railway  financing  will,  therefore,  relate  largely  to  the  effect 
which  these  debts  to  the  government  will  tend  to  have  on  general 
railway  credit. 

In  short,  there  are  so  many  uncertainties  in  the  future  of  the 
American  railways,  dependent  on  the  outcome  of  the  legislation 
now  pending  or  to  be  proposed,  that  no  detailed  discussion  can  be 
undertaken  here  as  to  the  manner  in  which  the  financial  needs  of 


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the  railways  are  likely  to  be  met.  The  amounts  needed  annually 
will  unquestionably  be  large.  If  the  government  limits  the 
profits  of  railways  in  the  future,  the  amount  they  may  devote  out 
of  surplus  to  new  improvements  will  be  relatively  small,  the 
great  bulk  coming  from  the  sale  of  securities.  If  railway  securi- 
ties are  in  any  way  supported  by  the  government,  the  difficulty  of 
placing  them  in  the  hands  of  investors  will  be  greatly  lessened. 
Even  if  the  government  has  nothing  directly  to  do  with  the  in- 
tegrity of  railway  securities,  it  might  provide  such  assurances  of 
adequate  railway  income  as  would  bring  virtually  the  same  result, 
although  in  a different  manner.  - Whatever  the  method,  the  prob- 
lem is  bound  to  be  both  difficult  and  complicated.  My  own 
feeling  is  that  the  problem  as  outlined  above  has  been  conserva- 
tively stated.  For  example,  the  physical  needs  are  quite  likely 
to  be  greater  than  those  described:  500  miles  of  new  line  are  a 
pitifully  small  addition  to  our  railway  system  each  year,  for  it 
could  easily  be  5,000  without  approaching  the  saturation  point  in 
railway  construction  for  a long  time.  Again,  the  terminal  facili- 
ties needed  by  the  railways  may  alone  exceed,  in  annual  cost,  the 
amount  included  jn  the  estimate  for  other  facilities  than  new 
mileage  and  new  equipment.  Still  further,  the  allowance  made 
for  the  increased  cost  of  everything  that  goes  into  railway  improve- 
ments, and  especially  for  increased  labor  costs,  is  moderate.  All 
things  considered,  the  financial  needs  would  appear  likely  to  be 
closer  to  the  upper  than  the  lower  of  the  two  limits  tentatively 
taken  as  a standard. 


